Mesaj lung: For sure, markets don’t like large debt and fiscal deficits, but they also don’t like low growth. Take the recent downgrades of several European countries. Were they purely the result of fiscal problems? No. Look at the words used by Standard & Poor’s: “a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.”

Some of our analytical work at the IMF makes this point clearly. It shows that lower debt ratios and deficits lead to lower interest rates on government bonds, but so too does faster short-term growth. So, when countries tighten fiscal policy and the economy slows, some of the gains from better fiscal fundamentals will be lost through lower growth. We also see some evidence of a nonlinear relationship between growth and sovereign bond spreads. Spreads are more likely to increase when growth is already low and the fiscal tightening is large (see Figure 1). If growth falls enough as a result of a fiscal tightening, interest rates could actually rise as the deficit falls.